A Very Incomplete Guide to Convertible Notes

If you are a venture capitalist and you are reading this, you probably already have an incredibly strong grasp of what a convertible debt note means in a startup-centered context. But if you are a first time entrepreneur or someone trying to wrap your head around the VC industry, this is a good blog for you. Convertible Notes are one of the most important and most misunderstood financing tools when it comes to startups. They also come in all sorts of shapes and sizes, so to understand what a convertible note is all about, you really need to dig into the weeds. There is way to much to discuss when it comes to convertible notes, so I am going to try and only touch on the highlights.

To put it plainly, a convertible note is an instrument that venture capitalists can utilize to invest in a company at the earliest stages. Convertible notes are very similar to preferred stock and common equity, but have some very key differences. First, convertible notes are not equity - they are debt instruments that can convert into a form of equity (either common or preferred stock). Convertible notes have a maturity date when they come due, and just like debt and they can carry interest. However, it shouldn’t be viewed the same as a bank loan precisely because it can convert. Convertible notes should be viewed almost like warrants, just with a little more juice. And as a result, almost everyone who purchases a convertible note probably hopes to convert it at some point in the future.

So why don’t purchasers of convertible notes just try and buy equity or preferred stock? When would somebody utilize a convertible note structure? The most typical occurrence of a convertible note is during the very early stages of a company’s financing, before a lot of market traction and any semblance of corporate maturity. The most frequent buyers of convertible notes are angel investors, pre-seed investors, and any other very early investors. The reasons for this, which will hopefully become even more clear as you read this post, are (i) convertible notes delay having to value a company, (ii) convertible notes are easier to create and purchase from a legal and structural standpoint, and (iii) convertible notes greatly simplify things. As a company still tries to figure itself out, it becomes very difficult to value a piece of equity in that company. A convertible note doesn’t muck up the capital structure of a company and doesn’t require too much onerous corporate restructuring.

What are some important convertible note features? A lot of convertible notes will have conversion caps associated with their conversion process. The conversion cap acts as the pre-money valuation for a company, but it should be noted that it is NOT the valuation, just a proxy. Conversion caps are agreements between the note issuer and the note holder that when a note converts, the price per share of each new stock unit held will be based on that conversion price. In other words, the conversion cap helps determine how much of a company the convertible note holders will own once converted. While the math utilized to calculate the number of shares to be assigned to the convertible notes can get a little complicated and hairy it actually is a straightforward process as long as you account for it ahead of your next financing. [Some convertible notes don’t have a conversion cap, which is a discussion for a future blog post.]

Convertible notes also carry interest rates. I won’t go into too much detail about how interest is calculated because there are other websites that can do a better job of that. There are some differing terms that account for interest rate variability, such as simple interest vs compound interest, so just make sure you really pay attention to how an interest rate is calculated in the final deal docs. Interest for convertible notes is moderately unique in that it is not due until maturity, instead of having monthly or quarterly payments. What typically occurs with interest is that it accrues and becomes a part of how much of the convertible note that a note holder owns. In other words, the interest on a note accumulates to be included in the conversion calculation - if you invest $200,000 and get $10,000 of interest, the amount that gets converted into equity is $210,000.

How does it convert? This is actually not such a tricky question. Typically, notes explain in excruciating detail all of the varying scenarios that can result in conversion into equity, but there is one that you should pay extra special attention to. During a “qualified financing” convertible notes convert automatically - this is potentially the most common form of note conversion. A qualified financing is a capitalized term in a term sheet that explains how much money and in what form a company has to raise in order for notes to convert automatically. Typically, the amount required can be negotiated based on what the company expects to raise during its next round. This form of conversion is typically mandatory for the note holder, because the company wants to make sure that it’s capitalization is as clean and straightforward as possible for future investors. But the qualified financing also prevents the conversion in the scenario of a bridge round or some other financing event that doesn’t really need convertible note conversion. So to break it down, if a qualified financing is defined as $1 million of preferred stock, then a convertible note has to convert into that preferred stock once a company raises beyond that threshold. But if the company raises less than $1 million, then a convertible note does not have to convert.

Is it equity? I think, based on some of my early musings in this blog post, you have come to a conclusion for this question for yourself. However, the answer to this question, and every question in finance, is “it depends”.

Peter G Schmidt